Overview

Derivatives have made the international and financial headlines in the past for mostly with their association with
spectacular losses or institutional collapses. But market players have traded derivatives successfully for centuries
and the daily international turnover in derivatives trading runs into billions of dollars.
Are derivative instruments that can only be traded by experienced, specialist traders? Although it is true that
complicated mathematical models are used for pricing some derivatives, the basic concepts and principles
underpinning derivatives and their trading are quite easy to grasp and understand. Indeed, derivatives are used
increasingly by market players ranging from governments, corporate treasurers, dealers and brokers and
individual investors.
Indian scenario
While forward contracts and exchange traded in futures has grown by leaps and bound, Indian stock markets
have been largely slow to these global changes. However, in the last few years, there has been substantial
improvement in the functioning of the securities market. Requirements of adequate capitalization for market
intermediaries, margining and establishment of clearing corporations have reduced market and credit risks.
However, there were inadequate advanced risk management tools. And after the ICE (Information,
Communication, Entertainment) meltdown the market regulator felt that in order to deepen and strengthen the
cash market trading of derivatives like futures and options was imperative.
Why have derivatives?
Derivatives have become very important in the field finance. They are very important financial instruments for risk
management as they allow risks to be separated and traded. Derivatives are used to shift risk and act as a form
of insurance. This shift of risk means that each party involved in the contract should be able to identify all the
risks involved before the contract is agreed. It is also important to remember that derivatives are derived from an
underlying asset. This means that risks in trading derivatives may change depending on what happens to the
underlying asset.
A derivative is a product whose value is derived from the value of an underlying asset, index or reference rate.
The underlying asset can be equity, forex, commodity or any other asset. For example, if the settlement price of a
derivative is based on the stock price of a stock for e.g. Infosys, which frequently changes on a daily basis, then
the derivative risks are also changing on a daily basis. This means that derivative risks and positions must be
monitored constantly.
The purpose of this Learning Centre is to introduce the basic concepts and principles of derivatives.
We will try and understand
What are derivatives?
Why have derivatives at all?
How are derivatives traded and used?
In subsequent lessons we will try and understand how exactly will an underlying asset effect the movement of a
derivative instrument and how is it traded and how one can profit from these instruments.
What are forward contracts?
Derivatives as a term conjures up visions of complex numeric calculations, speculative dealings and comes
across as an instrument which is the prerogative of a few 'smart finance professionals'. In reality it is not so. In
fact, a derivative transaction helps cover risk, which would arise on the trading of securities on which the
derivative is based and a small investor, can benefit immensely.
A derivative security can be defined as a security whose value depends on the values of other underlying
variables. Very often, the variables underlying the derivative securities are the prices of traded securities.
Let us take an example of a simple derivative contract:
Ram buys a futures contract.
He will make a profit of Rs 1000 if the price of Infosys rises by Rs 1000.
If the price is unchanged Ram will receive nothing.
If the stock price of Infosys falls by Rs 800 he will lose Rs 800.
As we can see, the above contract depends upon the price of the Infosys scrip, which is the underlying security.
Similarly, futures trading has already started in Sensex futures and Nifty futures. The underlying security in this
case is the BSE Sensex and NSE Nifty.
Derivatives and futures are basically of 3 types:
Forwards and Futures
Options
Swaps
Forward contract
A forward contract is the simplest mode of a derivative transaction. It is an agreement to buy or sell an asset (of a
specified quantity) at a certain future time for a certain price. No cash is exchanged when the contract is entered
into.
Illustration 1:
Shyam wants to buy a TV, which costs Rs 10,000 but he has no cash to buy it outright. He can only buy it 3
months hence. He, however, fears that prices of televisions will rise 3 months from now. So in order to protect
himself from the rise in prices Shyam enters into a contract with the TV dealer that 3 months from now he will buy
the TV for Rs 10,000. What Shyam is doing is that he is locking the current price of a TV for a forward contract.
The forward contract is settled at maturity. The dealer will deliver the asset to Shyam at the end of three months
and Shyam in turn will pay cash equivalent to the TV price on delivery.
Illustration 2:
Ram is an importer who has to make a payment for his consignment in six months time. In order to meet his
payment obligation he has to buy dollars six months from today. However, he is not sure what the Re/$ rate will
be then. In order to be sure of his expenditure he will enter into a contract with a bank to buy dollars six months
from now at a decided rate. As he is entering into a contract on a future date it is a forward contract and the
underlying security is the foreign currency.
The difference between a share and derivative is that shares/securities is an asset while derivative instrument is
a contract
What is an Index?
To understand the use and functioning of the index derivatives markets, it is necessary to understand the
underlying index. A stock index represents the change in value of a set of stocks, which constitute the index. A
market index is very important for the market players as it acts as a barometer for market behavior and as an
underlying in derivative instruments such as index futures.
The Sensex and Nifty
In India the most popular indices have been the BSE Sensex and S&P CNX Nifty. The BSE Sensex has 30
stocks comprising the index which are selected based on market capitalization, industry representation, trading
frequency etc. It represents 30 large well-established and financially sound companies. The Sensex represents a
broad spectrum of companies in a variety of industries. It represents 14 major industry groups. Then there is a
BSE national index and BSE 200. However, trading in index futures has only commenced on the BSE Sensex.
While the BSE Sensex was the first stock market index in the country, Nifty was launched by the National Stock
Exchange in April 1996 taking the base of November 3, 1995. The Nifty index consists of shares of 50 companies
with each having a market capitalization of more than Rs 500 crore.
Futures and stock indices
For understanding of stock index futures a thorough knowledge of the composition of indexes is essential.
Choosing the right index is important in choosing the right contract for speculation or hedging. Since for
speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the
relationship between the stocks being hedged and the characteristics of the index.
Choosing and understanding the right index is important as the movement of stock index futures is quite similar
to that of the underlying stock index. Volatility of the futures indexes is generally greater than spot stock indexes.
Everytime an investor takes a long or short position on a stock, he also has an hidden exposure to the Nifty or
Sensex. As most often stock values fall in tune with the entire market sentiment and rise when the market as a
whole is rising.
Retail investors will find the index derivatives useful due to the high correlation of the index with their
portfolio/stock and low cost associated with using index futures for hedging.
Understanding index futures
A futures contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a
certain price. Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and
helps a trader to take a view on the market as a whole.
Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy a
futures contract and hope for a price rise on the futures contract when the rally occurs. We shall learn in
subsequent lessons how one can leverage ones position by taking position in the futures market.
In India we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months
duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month and
simultaneously a new contract is introduced for trading after expiry of a contract.
Example:
Futures contract in September 2010
Contract month Expiry/settlement
September 2010 September 30
October 2010 October 28
November 2010 November 25
The permitted lot size is 50 or multiples thereof for the Nifty. That is you buy one Nifty contract the total deal
value will be 50*5500 (Nifty value)= Rs 2,75,000.
In the case of BSE Sensex the market lot is 15. That is you buy one Sensex futures the total value will be
15*18200 (Sensex value)= Rs 2,73,000.
The index futures symbols are represented as follows:
BSE NSE
BSXSEP2010 (September contract) FUTDXNIFTY30-Sep2010
BSXOCT2010 (October contract) FUTDXNIFTY28-OCT2010
BSXNOV2010 (November contract) FUTDXNIFTY25-NOV2010
In subsequent lessons we will learn about the pricing of index futures.
Hedging
We have seen how one can take a view on the market with the help of index futures. The other benefit of trading
in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect
his portfolio from value erosion let us take an example.
Illustration
Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000.
The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.
Cost (Rs) Selling price Profit
1000 4000 3000
However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in
the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam
honours the contract Ram will offer a discount of Rs 1000 as incentive.
Shyam defaults Shyam honours
1000 (Initial Investment) 3000 (Initial profit)
1000 (penalty from Shyam) (-1000) discount given to Shyam
- (No gain/loss) 2000 (Net gain)
As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If
Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against
default and protected his initial investment.
The above example explains the concept of hedging. Let us try understanding how one can use hedging in a real
life scenario.
Stocks carry two types of risk - company specific and market risk. While company risk can be minimized by
diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the
market risk? Market risk can be known from Beta.
Beta measures the relationship between movement of the index to the movement of the stock. The beta
measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose
value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases
by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your
losses.
Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a
position, a market player needs to take an equal and opposite position in the futures market to the one held in the
cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you
have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of
S&P CNX Nifty futures.
Steps:
1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to
assume that it is 1.
2. Short sell the index in such a quantum that the gain on a unit decrease in the index
would offset the losses on the rest of his portfolio. This is achieved by multiplying the
relative volatility of the portfolio by the market value of his holdings.
Therefore in the above scenario we have to shortsell 1.2 * 1 million = 1.2 million worth of Nifty.
Now let us study the impact on the overall gain/loss that accrues:
Index up 10% Index down 10%
Gain/(Loss) in Portfolio Rs 120,000 (Rs 120,000)
Gain/(Loss) in Futures (Rs 120,000) Rs 120,000
Net Effect Nil Nil
As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a
cost, one has to forego any gains that arise out of improvement in the overall sentiment. Then why does one
invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his
portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would
increase.
The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse
position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market.
Speculation
Speculators are those who do not have any position on which they enter in futures and options market. They only
have a particular view on the market, stock, commodity etc. In short, speculators put their money at risk in the
hope of profiting from an anticipated price change. They consider various factors such as demand supply, market
positions, open interests, economic fundamentals and other data to take their positions.
Illustration
Ram is a trader but has no time to track and analyze stocks. However, he fancies his chances in predicting the
market trend. So instead of buying different stocks he buys Sensex Futures.
On September 1, 2010, he buys 100 Sensex futures @ 18200 on expectations that the index will rise in future.
On September 28, 2010, the Sensex rises to 19200 and at that time he sells an equal number of contracts to
close out his position.
Selling Price : 19200 x 100 = Rs 19,20,000
Less: Purchase Cost: 18200 x 100 = Rs 18,20,000
Net gain = Rs 1,00,000
Ram has made a profit of Rs 1,00,000 by taking a call on the future value of the Sensex. However, if the Sensex
had fallen he would have made a loss. Similarly, if would have been bearish he could have sold Sensex futures
and made a profit from a falling profit. In index futures players can have a long-term view of the market up to
atleast 3 months.
Arbitrage
An arbitrageur is basically risk averse. He enters into those contracts were he can earn riskless profits. When
markets are imperfect, buying in one market and simultaneously selling in other market gives riskless profit.
Arbitrageurs are always in the look out for such imperfections.
In the futures market one can take advantages of arbitrage opportunities by buying from lower priced market and
selling at the higher priced market. In index futures arbitrage is possible between the spot market and the futures
market (NSE has provided a special software for buying all 50 Nifty stocks in the spot market.
Take the case of the NSE Nifty.
Assume that Nifty is at 5500 and 3 month's Nifty futures is at 6000.
The futures price of Nifty futures can be worked out by taking the interest cost of 3
months into account.
If there is a difference then arbitrage opportunity exists.
Let us take the example of single stock to understand the concept better. If Wipro is quoted at Rs 1000 per share
and the 3 months futures of Wipro is Rs 1070 then one can purchase Wipro at Rs 1000 in spot by borrowing @
12% annum for 3 months and sell Wipro futures for 3 months at Rs 1070.
Sale = 1070
Cost= 1000+30 = 1030
Arbitrage profit = 40
These kind of imperfections continue to exist in the markets but one has to be alert to the opportunities as they
tend to get exhausted very fast.
Pricing of Index Futures
The index futures are the most popular futures contracts as they can be used in a variety of ways by various
participants in the market.
How many times have you felt of making risk-less profits by arbitraging between the underlying and futures
markets. If so, you need to know the cost-of-carry model to understand the dynamics of pricing that constitute the
estimation of fair value of futures.
The cost of carry model
The cost-of-carry model where the price of the contract is defined as:
F=S+C
where:
F : Futures price
S : Spot price
C : Holding costs or carry costs
If F < S+C or F > S+C, arbitrage opportunities would exist i.e. whenever the futures price moves away from the
fair value, there would be chances for arbitrage.
If Wipro is quoted at Rs 1000 per share and the 3 months futures of Wipro is Rs 1070 then one can purchase
Wipro at Rs 1000 in spot by borrowing @ 12% annum for 3 months and sell Wipro futures for 3 months at Rs
1070.
Here F=1000+30=1030 and is less than prevailing futures price and hence there are chances of arbitrage.
Sale = 1070
Cost = 1000+30 = 1030
Arbitrage profit = 40

However, one has to remember that the components of holding cost vary with contracts on different assets.
Futures pricing in case of dividend yield
We have seen how we have to consider the cost of finance to arrive at the futures index value. However, the cost
of finance has to be adjusted for benefits of dividends and interest income. In the case of equity futures, the
holding cost is the cost of financing minus the dividend returns.
Example
Suppose a stock portfolio has a value of Rs 100 and has an annual dividend yield of 3% which is earned
throughout the year and finance rate=10% the fair value of the stock index portfolio after one year will be F= Rs
100 + Rs 100 * (0.10 - 0.03)
Futures price = Rs 107
If the actual futures price of one-year contract is Rs 109. An arbitrageur can buy the stock at Rs 100, borrowing
the fund at the rate of 10% and simultaneously sell futures at Rs 109. At the end of the year, the arbitrageur
would collect Rs 3 for dividends, deliver the stock portfolio at Rs 109 and repay the loan of Rs 100 and interest of
Rs 10.
The net profit would be Rs 109 + Rs 3 - Rs 100 - Rs 10 = Rs 2.
Thus, we can arrive at the fair value in the case of dividend yield.
Trading strategies
Speculation
We have seen earlier that trading in index futures helps in taking a view of the market, hedging, speculation and
arbitrage. In this module we will see one can trade in index futures and use forward contracts in each of these
instances.
Taking a view of the market
Have you ever felt that the market would go down on a particular day and feared that your portfolio value would
erode?
There are two options available
Option 1: Sell liquid stocks such as Reliance
Option 2: Sell the entire index portfolio
The problem in both the above cases is that it would be very cumbersome and costly to sell all the stocks in the
index. And in the process one could be vulnerable to company specific risk. So what is the option? The best thing
to do is to sell index futures.
Illustration:
Scenario 1:
On September 01, 2010, 'X' feels that the market will rise so he buys 50 Nifty with an expiry date of September
30,2010 at an index price of 5500 costing Rs 2,75,000 (50*5500).
On September 30 the Nifty futures have risen to 5650 so he squares off his position at 5650.
'X' makes a profit of Rs 7500 (50*150)
Scenario 2:
On September 10, 2010, 'X' feels that the market will fall so he sells 50 Nifty with an expiry date of September 30
at an index price of 5550 costing Rs 2,77,500 (50*5550).
On September 30 the Nifty futures falls to 5340 so he squares off his position at 5340.
'X' makes a profit of Rs 10,500 (210*50).
In the above cases 'X' has profited from speculation i.e. he has wagered in the hope of profiting from an
anticipated price change.
Hedging
Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk.
The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a
stock market risk is the stock's Beta. The Beta of stocks are available on the www.nseindia.com.
While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce
the risk to the minimum.
Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company
made it worth a lot more as compared with what the market thinks?
Have you ever been a 'stockpicker' and carefully purchased a stock based on a sense that it was worth more
than the market price?
A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of
risks:
1. His understanding can be wrong, and the company is really not worth more than the
market price or
2. The entire market moves against him and generates losses even though the
underlying idea was correct.
Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long
position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental
baggage i.e. a part long position of Nifty.
Let us see how one can hedge positions using index futures:
X' holds HLL worth Rs 5.8 lakh at Rs 290 per share on September 10, 2010. Assuming that the beta of HLL is
1.13. How much Nifty futures does 'X' have to sell if the index futures is ruling at 5450?
To hedge he needs to sell 5.8 lakh * 1.13 = Rs 6,55,400 on the index futures i.e. 121 Nifty futures
(1017000/5450).
On September 25, 2010, the Nifty futures is at 5340 and HLL is at 285. 'X' closes both positions earning Rs
3,3310 i.e. his position on HLL drops by Rs 10000 and his short position on Nifty gains Rs 13310 (121*70).
Therefore, the net gain is 13310-10000 = Rs 3,310.
Let us take another example when one has a portfolio of stocks:
Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by
using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk
If the index is at 5500 * 50 (market lot) = Rs 2,75,000
The number of contracts to be sold is:
a. 1.19*10 crore = 11.9 crore
No of contracts in Nifty =11.9 crore / 2.75 laks
= 433 contracts

If you sell more than 433 contracts you are overhedged and sell less than 433 contracts you are underhedged.
Thus, we have seen how one can hedge their portfolio against market risk.
Margins
The margining system is based on the JR Verma Committee recommendations. The actual margining happens
on a daily basis while online position monitoring is done on an intra-day basis.
Daily margining is of two types:
1. Initial margins
2. Mark-to-market profit/loss
The computation of initial margin on the futures market is done using the concept of Value-at-Risk (VaR). The
initial margin amount is large enough to cover a one-day loss that can be encountered on 99% of the days. VaR
methodology seeks to measure the amount of value that a portfolio may stand to lose within a certain horizon
time period (one day for the clearing corporation) due to potential changes in the underlying asset market price.
Initial margin amount computed using VaR is collected up-front.
The daily settlement process called "mark-to-market" provides for collection of losses that have already
occurred (historic losses) whereas initial margin seeks to safeguard against potential losses on outstanding
positions. The mark-to-market settlement is done in cash.
Let us take a hypothetical trading activity of a client of a NSE futures division to demonstrate the margins
payments that would occur.
A client purchases 50 units of FUTIDX NIFTY 29JUN2001 at Rs 5400.
The initial margin payable as calculated by VaR is 15%.
Total long position = Rs 2,70,000 (50*5400)
Initial margin (15%) = Rs 40,500
Assuming that the contract will close on Day + 2 the mark-to-market position will look as follows:
Position on Day 1
Close Price Loss Margin released Net cash outflow
5300*50 =2,67,500 2,500 (2,70,000- 2,67,500) 375 (40,500- 40,125) 2125 (2500- 375)
Payment to be made (2125)
New position on Day 2
Value of new position = 5500*50 = Rs 2,75,000
Margin = Rs 41,250
Close Price Gain Net cash inflow
5500*50 =2,75,000 7500 (2,75,000-2,67,500) 5000
Payment to be recd

Margin account*
Initial margin = Rs 40,500
Margin released (Day 1) = (-) Rs 375
Position on Day 2 Rs 40,125
Net gain/loss
Day 1 (loss) = (2500)
Day 2 Gain = Rs 7500
Total Gain = Rs 5000
The client has made a profit of Rs 50000 at the end of Day 2
Settlements
All trades in the futures market are cash settled on a T+1 basis and all positions (buy/sell) which are not closed
out will be marked-to-market. The closing price of the index futures will be the daily settlement price and the
position will be carried to the next day at the settlement price.
The most common way of liquidating an open position is to execute an offsetting futures transaction by which the
initial transaction is squared up. The initial buyer liquidates his long position by selling identical futures contract.
In index futures the other way of settlement is cash settled at the final settlement. At the end of the contract
period the difference between the contract value and closing index value is paid.
How to read the futures data sheet?
Understanding and deciphering the prices of futures trade is the first challenge for anyone planning to venture in
futures trading. Economic dailies and exchange websites www.nseindia.com and www.bseindia.com are some of
the sources where one can look for the daily quotes. Your website has a daily market commentary, which carries
end of day derivatives summary alongwith the quotes.
The first step is start tracking the end of day prices. Closing prices, Trading Volumes and Open Interest are the
three primary data we carry with Index option quotes. The most important parameter are the actual prices, the
high, low, open, close, last traded prices and the intra-day prices and to track them one has to have access to
real time prices.
The following table shows how futures data will be generally displayed in the business papers daily.
Instru
ment
Type
Under
lying
Expiry
Date
Opt
ion
Typ
e
Stri
ke
Pri
ce
Hig
h
Pric
e
Low
Pric
e
Prev
Clos
e
Last
Pric
e
Num
ber
of
contr
acts
trade
d
Turno
ver in
Rs.
Lakhs
Under
lying
Value
FUTID
X
NIFTY
30SEP
2010
- -
546
5.00
539
1.35
541
5.75
542
9.60
4355
64
11827
08.71
5417.2
5
FUTID
X
NIFTY
30SEP
2010
- -
546
8.25
539
8.00
542
1.05
543
5.00
1289
2
35037.
75
5417.2
5
FUTID
X
NIFTY
30SEP
2010
- -
546
7.00
540
1.40
542
2.05
543
5.70
923
2509.6
2
5417.2
5
Source: NSE
The first column explains contact being taded For e.g FUTIDX stands for the Index
futures contract.
Second columns explains the underlying For e.g Nifty
The third column gives the expiry date for the contract.
The most useful measure of market activity is Open interest, which is also published by exchanges and used for
technical analysis. Open interest indicates the liquidity of a market and is the total number of contracts, which are
still outstanding in a futures market for a specified futures contract.
A futures contract is formed when a buyer and a seller take opposite positions in a transaction. This means that
the buyer goes long and the seller goes short. Open interest is calculated by looking at either the total number of
outstanding long or short positions - not both.
Open interest is therefore a measure of contracts that have not been matched and closed out. The number of
open long contracts must equal exactly the number of open short contracts.
Action Resulting open interest
New buyer (long) and new seller (short) Trade to form a new
contract.
Rise
Existing buyer sells and existing seller buys -The old contract is
closed.
Fall
New buyer buys from existing buyer. The Existing buyer closes
his position by selling to new buyer.
No change - there is no increase in long
contracts being held
Existing seller buys from new seller. The Existing seller closes
his position by buying from new seller.
No change - there is no increase in
short contracts being held
Open interest is also used in conjunction with other technical analysis chart patterns and indicators to gauge
market signals. The following chart may help with these signals.
Price Open interest Market

Strong

Warning signal

Weak

Warning signal
The warning sign indicates that the Open interest is not supporting the price direction.
Selecting the right index
In selecting the index and contract month one should consider the following points.
Expiration date: If the investor has a month or two's view about the market then he should choose that index
futures which has a similar time left for expiry.
Liquidity: The index and the contract month, which is the most liquid must be used. This will save cost because
of the low bid-ask spread. This also saves hedging costs.
Stock should be correlated to the index: The stock to be hedged should have a correlation with the index
selected.
Potential mispricing: One should sell index futures contract which is overpriced. In such an event one can not
only hedge but also earn some profit in selling high.
In a nutshell, one should hedge by using the most popular and fairly priced index and delivery month should not
be very far since liquidity and predictability of very few contracts are low.
Glossary
Backwardation: A market where future prices of distant contract months are lower than the near months.
Basis: The difference between the Index and the respective contract is the basis i.e. cash netted for the Futures
price. A negative basis means Futures are at a premium to cash and vice versa. It is the strengthening and
weakening of basis that is tracked by market players i.e. whether the basis is widening or narrowing. A widening
of basis is indicative of increasing longs and narrowing means increasing short positions.
Basis Point: It is equal to one hundredth of a percentage point
Contango market: This is a market where futures prices are higher for distant contracts than for nearby delivery
months.
Cost of carry: is an indicator of the demand-supply forces in the Futures market. It basically means the
annualized interest cost players decide to pay (receive) for buying (selling) a respective contract. A higher carry
cost is indicative of buying pressure and vice versa. Carry Cost is a widely used parameter not only because it is
more interpretable being an annualized figure, as compared to basis (Cash netted for Futures) but also because
it works well with the trio of Price, Volume and Open Interest in highlighting the market trend.
Delivery month: Is the month in which delivery of futures contracts need to be made.
Delivery price: The price fixed by the clearinghouse at which deliveries on futures contracts are invoiced. Also
known as the expiry price or the settlement price.
Derivative: A financial instrument designed to replicate an underlying security for the purpose of transferring risk.
Fair value: Theoretical value of a futures contract derived from a mathematical model of valuation.
Hedge Ratio: The Hedge Ratio is defined as the number of Futures contracts required to buy or sell so as to
provide the maximum offset of risk. This depends on the
Value of a Futures contract;
Value of the portfolio to be Hedged; and
Sensitivity of the movement of the portfolio price to that of the Index (Called Beta).
The Hedge Ratio is closely linked to the correlation between the asset (portfolio of shares) to be hedged and
underlying (index) from which Future is derived.
Initial margin: The money a customer needs to pay as deposit to establish a position in the futures market. The
basic aim of Initial margin is to cover the largest potential loss in one day.
Mark-to-market: The daily revaluation of open positions to reflect profits and losses based on closing market
prices at the end of the trading day.
Forward contract: In a forward contract, two parties agree to do a trade at some future date, at a stated price
and quantity. No money changes hands at the time the deal is signed.
Futures contract: A futures contract is similar to a forward contract in terms of its working. The difference is that
contracts are standardized and trading is centralized. Futures markets are highly liquid and there is no
counterparty risk due to the presence of a clearinghouse, which becomes the counterparty to both sides of each
transaction and guarantees the trade.
Far contract: The future that is furthest from its delivery month i. e. has the longest maturity.
Speculation: Trading on anticipated price changes, where the trader does not hold another position which will
offset any such price movements.
Spread ratio: The number of futures contracts bought, divided by the number of futures contracts sold.
VaR: Value at Risk. A risk management methodology, which attempts to measure the maximum loss possible on
a particular position, with a specified level of certainty or confidence.
Strike Price: The price at which an option holder may buy or sell the underlying asset, which is specified in an
option contract.